The huge changes in monetary policy that Europe's central banks have been making over the past 12-18 months are putting the spotlight on the funding profiles of the region's banks. S&P Global Ratings believes that European banks' funding profiles have stood up relatively well to the changes so far. However, funding costs will inevitably continue to rise as the deposit market becomes tighter and competition picks up. As a result, we expect that large rated European banks' net interest margins (NIMs) and net interest income (NII) will peak later this year.

European banks have largely kept their funding costs low since mid-2022, despite rising policy rates. Overall, the average deposit beta--the share of the increase in policy rates that banks pass through to the interest rates on deposits--is only 20%, which, for banks, compares favorably with historical precedents. There are significant differences across countries, however, with deposit betas ranging from only around 5% in Cyprus, Ireland, and Spain to above 30% in France and Luxembourg. In most Central and Eastern European countries, deposit repricing has been far slower and less pronounced than the increase in policy rates, with the notable exception of the Czech Republic.

We see two key drivers of these differences. First, banks' starting levels of liquidity, with those holding more liquidity less prone to compete for deposits and therefore pay up, and second, banks' deposit base profiles, with banks that have strong current accounts and household deposit franchises less likely to see deposit repricing. Government intervention, competition between banks, and customer behavior also play a part.

In 2023-2024, we expect that protecting liquidity will come at an increasing cost for European banks. Central bank actions to reduce their balance sheets will continue to drain liquidity from the financial system and likely lead to some deposit outflows. Based on the current market consensus, we expect that quantitative tightening could lead to around €400 billion of deposit outflows from eurozone banks by year-end 2023, representing 3.2% of all customer deposits. However, with sharply reducing lending growth and elevated funding and liquidity ratios, our base case remains that these incremental funding pressures will represent a cost challenge rather than a funding availability problem.

That said, the pace of quantitative tightening remains a key uncertainty for European banks' funding costs and financial performance. As they proceed, we expect that European central banks will communicate their intentions carefully, given the potential impact on the financial system. In doing so, they face several uncertainties, including governments' future financing needs; the quality of bank and nonbank financial institutions' management of interest rate risk; and the repercussions of a possible increase in market volatility for the banking sector.

Central banks have many tools to address financial stability issues should they arise. Yet the inability of nonbank financial actors to access emergency central bank funding in a stress scenario means that banks need to carefully manage the risks emanating from their business with these nonbanks (see "When Rates Rise: Risks To Global Banks Could Emerge From The Shadows," published Feb. 16, 2023).

Monetary Policy Normalization Involves More Than Increases In Policy Rates

The European Central Bank (ECB) started to normalize its monetary policy a year ago, joining other major central banks such as the Bank of England (BoE) and the U.S. Federal Reserve (Fed). Persistently high inflation in Europe in the past 12-18 months has greatly accelerated this multiyear process compared to initial market expectations. Our economists expect that Europe's central banks will maintain a data-driven approach as they pursue monetary policy normalization, with core inflation expectations likely to remain the main indicator.

The first move by European central banks has been to increase policy rates. Since the end of 2021, the BoE has raised rates by 490 basis points (bps), and our economists consider that rates could go higher still, reaching 5.25%-5.5% by the end of the summer if the bad news about inflation continues (see "Economic Outlook U.K. Q3 2023: Higher Rates Start To Bite," published June 26, 2023). Since July 2022, the ECB has increased its deposit facility rate to 3.5% from -0.5%. Our economists expect one more increase of 25 bps in July, taking the deposit facility rate to 3.75%, before pausing at that level (see "Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain," published June 26, 2023). Other European central banks have acted similarly, with the Swiss National bank, Swedish Rikbank, Norges Bank, and the Danish Central bank all forging ahead with hiking cycles.

In addition, the ECB has accelerated targeted longer-term refinancing operation (TLTRO) borrowing repayments since the fourth quarter of 2022. Eurozone banks had repaid half of the €2.2 trillion originally outstanding by mid-June 2023. As of end-December 2022, outstanding TLTRO borrowings still represented 6% of large eurozone banks' total liabilities and 72% of their excess liquidity buffers. The figures were higher in a handful of countries such as Italy, Greece, and France (see chart 1).

A total €480 billion of TLTRO debt matures at the end of June 2023, with French and Italian banks having estimated maturities of €220 billion and €143 billion, respectively. The remaining repayments are spread out until the end of 2024. As the ECB returns to normal bank refinancing operations, our economists consider that it could also discuss resuming standard fixed allotment procedures, whereby it auctions off limited amounts of funding, as opposed to the full allotment procedures it has followed in recent years.

Chart 1

Finally, in March 2023, the ECB stopped fully reinvesting the maturing bonds it holds under its asset purchase program at a rate of €15 billion per month. From July, the ECB will stop fully reinvesting maturing bonds under this program altogether. Market estimates are that this will remove €22 billion of excess liquidity from the financial system per month until end-2023.

In practice, the ECB is conducting a form of passive quantitative tightening, that is, withdrawing reserves on the repayment of maturing bonds. This is distinct from the BoE's and Fed's active quantitative tightening, which involves reselling bonds in the market and withdrawing the reserves they receive as a result of those trades. Our economists expect that the ECB's Governing Council will continue to discuss the pace of quantitative tightening, as maintaining such a large portfolio of bonds is not compatible with the ECB's inflation outlook, which remains above target for the next two years.

The BoE, on the other hand, stopped buying bonds at the end of 2021, ended the reinvestment of proceeds from maturing bonds in February 2022, and started actively selling bonds in November 2022. It is currently reducing its bond holdings by £80 billion per year. Its holdings peaked at £895 billion and were £824 billion as of June 21, 2023.

Rate Hikes Have Not Moved The Dial Much On Banks' Liquidity And Funding

On the whole, rising rates have not impinged much on European banks' liquidity positions and funding costs so far. The biggest impact has been on the demand for new loans, which has led to a sharp deceleration in lending growth. Eurozone banks met the first TLTRO repayments with liquidity on hand, and their regulatory liquidity and funding ratios barely moved as a result (see chart 2).

Chart 2

The stability of banks' regulatory ratios despite the TLTRO repayments partly reflects offsetting factors, mainly the return of the collateral that banks had pledged to the ECB to their balance sheets. The share of encumbered assets has declined to its lowest level since 2016, 25.8%, down from 28.5%. This means that eurozone banks can pledge additional assets to meet their refinancing needs, with those holding prime mortgages, and therefore able to tap the reliable covered bond markets, at a clear advantage.

Importantly, banks have achieved this stability of liquidity and funding metrics at a limited cost, despite rising policy rates. Since 2022, we have seen some migration of deposits from current accounts to higher-yielding fixed-term accounts, which have consequently risen to 17% of eurozone banks' total deposits from 12% in June 2022 (see chart 3). This marks a return to the 2019 level, but is still far below the level of around 30% before quantitative easing.

Chart 3

Deposit betas are still low

Overall, between June 2022 and April 2023, eurozone banks have maintained deposit betas at a low 20%. This average deposit beta is much lower than that at the start of the last ECB rate-hike cycle in December 2005 (see table 1). The same applies to betas on new loans, albeit to a lesser extent.

Table 1

In our view, a key reason for the difference in deposit betas is the overall availability of deposit funding in the banking system, one measure of which is the loan-to-deposit ratio. In 2005-2006, the average loan-to-deposit ratio in the eurozone stood at 138%, versus 95% today. In addition, the ECB's recent Financial Stability Review indicates that the pass-through of rates to depositors tends to be smaller at more liquid banks. Another reason for the difference in deposit betas is the speed of the interest rate rises, as passing on rising rates to depositors takes time, and the ECB has been much quicker in raising its policy rates this time round. Finally, the degree of competition between banks may have been greater before the global financial crisis, meaning more competition for deposits.

The rate of debt issuance is high

In terms of market funding, eurozone banks have maintained a high pace of issuance in recent months, with 2022 issuances 25% higher than the 2015-2019 average, and higher still in the first quarter of 2023. These issuances came at a greater cost though, with yields on investment-grade bank bonds rising by around 300 bps since January 2022 (see chart 4). Furthermore, there has been increasing differentiation in pricing, with senior preferred spreads widening relative to covered bond spreads. As a result, the average covered bond yield still stood below 3.0% at year-end 2022, whereas the average senior preferred yield was about 3.7%. This partly explains the significant increase in gross issuance of covered bonds to slightly above €180 billion in 2022 from around €100 billion in 2021 and 2020.

Chart 4

Banks have seen lending growth drop sharply

Since July 2022, the rise in interest rates has contributed to a sharp deceleration of lending growth, with the annual rate falling to 2.5% from 4.6% between June 2022 and April 2023. The decline in lending growth was much less pronounced in 2005-2006, with only a small dip to 9.2% from 9.5% over the first nine months of the rate-hike cycle, and to 5.5% by the end of the cycle in July 2008.

The deterioration in lending growth is largely due to the strong decline in loan demand, especially for long-term loans such as mortgages, which is itself the result of the increase in interest rates. Banks' tightening of lending standards has also played an important role. To a large extent, the decline in lending growth is an intended consequence of the ECB's monetary policy normalization. For banks, it means lower prospects for growth in NII, but also lower funding pressures.

The Uneven Rise In Deposit Rates Largely Reflects Differences In Banks' Liquidity And Funding

Although the rise in average deposit costs has been limited so far, we have seen meaningful differences across eurozone banking systems, with deposit betas ranging from around 5% in Cyprus, Ireland, and Slovenia to above 30% in France and Luxembourg (see chart 5).

Chart 5

Most of the increase in the average deposit cost stems from the repricing of deposits, but a nonnegligible part also results from the migration of deposits from current accounts to fixed-term deposits, which carry much higher remuneration (see charts 6 and 7). Such migration has been particularly pronounced in Luxembourg, where fixed-term accounts increased to 26% of total deposits from 9% between June 2022 and April 2023. The rate of migration has been particularly low in many Southern European countries, including Italy, Spain, Malta, Portugal, and Cyprus, but also in Ireland.

Chart 6

Chart 7

The availability of deposits and liquidity levels are major factors in the evolution of deposit costs. We have found a correlation between the deposit betas in the eurozone since July 2022 and loan-to-deposit ratios and other regulatory measures of liquidity and funding strength (see charts 8, 9, and 10). This supports our view that banks' relative liquidity and funding positions play a key role in their repricing of deposits.

Banks price their deposits to attract the liquidity they need to meet their liquidity and funding targets. This means that funding costs rise more quickly and significantly for banks with tighter funding and liquidity positions, and those that cannot access the full breadth of the deposit market, notably through current or checking accounts, as well as term savings accounts.

Chart 8

Chart 9

Chart 10

Other factors likely to affect the rise in deposit costs are:

Government intervention

This is the case in France, where the rates on key deposit products are regulated and follow inflation. Governments in other countries may also step in to force banks to pass higher interest rates on to depositors and thereby prevent the topic gaining prominence in public and political debates.

The availability of alternative solutions for savers outside the banking system

Examples include money market funds, mutual funds, or life insurance products. For instance, the importance of the investment fund sector has contributed to the rise in banks' deposit costs in Luxembourg, as well as France and the Netherlands. However, parts of these savings in nonbanks tend to find their way back to banks, as insurers, for instance, invest in banks' covered bonds and other debt instruments. Another form of direct competition for bank deposits is the placement of sovereign issuances with private retail customers, for instance in Portugal, Spain, and Italy.

The level of competition in each banking system

There are significant differences in average deposit costs between countries, ranging from 0.1% in Cyprus to 1.6% in France. It is notable that the banks that have been most able to defend their funding costs so far are those operating in systems that have seen a banking crisis or consolidation in the past decade. This great variability across countries also reflects the imperfect nature of the banking union, as deposits are not allocated across borders according to their risks or returns. What's more, the first bank to increase its deposit rates could prompt the rest of the sector to follow for fear of deposit losses. We have seen this in the Czech Republic, for example.

The relative importance of commercial versus retail deposits in each country

This is a function of the relative wealth and savings of corporates and households, as retail deposits tend to be much less sensitive to rates than commercial deposits. Furthermore, the deposits of corporates operating in certain sectors are less stable during challenging economic conditions because of their increased liquidity needs.

Customer behavior and digitalization

Customers' level of financial literacy, as well as the means they use to manage their bank deposits, are key, as digital deposits can be moved more quickly for optimum benefits. The additional transparency around deposit rates arising from digital media is also relevant for overall customer behavior and deposit repricing.

Funding Costs Will Inevitably Continue To Rise, With Lending Profitability Likely To Peak Later This Year

Rated European banks are likely to see a further rise in their funding costs in 2023 and 2024. First, repaying the €1.1 trillion in TLTRO borrowings maturing by the end of 2024 will drag on their liquidity and funding ratios. Banking tremors in the first half of 2023 mean that banks' management teams are likely to remain cautious and keen to post healthy liquidity ratios. This will lead them to defend their deposit balances and limit lending growth. These actions will come at a cost to profitability, especially in a higher rate environment.

Second, deposit availability will likely decrease over time as net lending growth decelerates and central banks accelerate the pace of their balance sheet reduction. In the first four months of 2023, we have seen the annual growth rates for household and corporate deposits decline sharply, from 2.7% and 3.3% to 1.4% and 0.8%, respectively. It is therefore likely that we will see a decline in the stock of eurozone banks' deposits in the coming months, on the back of lower lending growth and the ECB's decreasing balance sheet.

Third, we expect that European banks will continue to issue significant amounts of wholesale debt in 2023 and 2024. For instance, we expect that their debt issuances to meet the minimum requirement for own funds and eligible liabilities (MREL) will stand at around €115 billion in 2023, with about half of that amount already issued in the first quarter (see chart 11).

While we acknowledge that the current interest rate environment and volatility make banks' funding plans particularly uncertain, we see two trends emerging among the top 50 rated European banks:

• A further increase in outstanding covered bonds by 13% over 2022-2024, as banks seek optimize funding costs; and
• Increases in outstanding senior nonpreferred, tier 2, and additional tier 1 liabilities of 12%, 5%, and 10%, respectively, as banks need to comply with subordinated MREL requirements and refinance maturing issuances.

Growth in the amount of outstanding senior preferred debt should stay limited, at 2% over 2022-2024. This is particularly the case for German, French, and Spanish banks, whose outstanding senior preferred debt we expect to slightly decrease over the same period (see chart 12).

Chart 11

Chart 12

In this context, we expect that our top 50 rated European banks' NIMs will peak later this year, with the median climbing to 2.0% in 2023 from 1.6% in 2021 and staying close to that level in 2024 (see chart 13). However, NIM trends vary across banking systems. NIM widening was particularly pronounced in the early phase of this cycle for rated banks in Ireland and the U.K., and we expect 40%-50% increases in NIMs by end-2023 compared to end-2021. On the contrary, NIM increases were much more limited in the Netherlands, France, and Switzerland, and we expect only single-digit to low-double-digit increases over the same two-year period.

Chart 13

Until 2025, we also expect that lending growth will continue to decelerate, due to both depressed demand and tighter bank underwriting. On average, growth in customer loans for the top 50 rated European banks stood at 3.3% in 2022, with some significant exceptions like Belgium (+9%), Sweden (+8%), and the Netherlands (-2%). We expect lending growth to be around 2.9% in 2023, 2.3% in 2024, and 2.1% in 2025.

Peaking NIMs and decelerating lending growth should lead to NII continuing to grow by low double digits in 2023, but plateauing thereafter (see chart 14). After climbing by 17% in 2022, we expect rated European banks' annual NII to jump by another 12% in 2023, but only by 3% in 2024. Although this trend is common to all European banking systems, its impact will vary, as the NII contribution to total revenue varies widely, from around 45% in France and Switzerland to more than 70% in Ireland, the Netherlands, and the U.K.

Chart 14

The top 50 rated European banks should maintain their funding profiles

Besides the evolution of NIMs and NII, we do not expect the normalization of monetary policies to have a material impact on our overall funding assessment of rated European banks. Of the top 50 rated European banks, 42 have an adequate funding profile. This means that we don't see these banks' funding profiles as meaningfully better or worse than those of their peers, and their liquidity profiles should make them reasonably resilient to stress. In addition, six banks have both strong liquidity and strong funding profiles, which raises their respective stand-alone credit profiles by one notch.

Quantitative Tightening Means Some Deposit Outflows, But Also Poses A Broader Risk

In our view, the impact of the ECB's quantitative tightening on eurozone banks' aggregate deposit levels should remain moderate in 2023 (see chart 15 and the Appendix). The market consensus is for a reduction of the ECB's asset purchase program portfolio of €22 billion per month between July and December 2023, meaning a total asset reduction of slightly over €200 billion.

In comparison, between April 2022 and February 2023, the Fed reduced its securities holdings by $533 billion, or 6% of all those outstanding. This reduction was accompanied by a decline in banks' customer deposits of $1 trillion or 6% of the total.

Assuming the same correlation between bank deposit outflows and central bank asset reductions as in the U.S., we estimate that eurozone banks could see customer deposit outflows of about €400 billion between March and December 2023, all else being equal, which would represent a 3.2% drop in customer deposits. This underpins our view of a moderate impact in 2023.

Chart 15

That said, our economists expect that the ECB's Governing Council could discuss accelerating the pace of quantitative tightening. As they proceed with this, we expect that European central banks will communicate their intentions carefully, given the potential impact on the financial system. In doing so, they face several major uncertainties that make their task particularly complex, namely:

The extent of borrowers' future financing needs, especially governments.   An unexpected increase in government funding needs, for instance, can lead to a rapid and excessive increase in yields and spreads, as seen in the U.K. in September 2022. This can, in turn, lead to financial instability.

The extent to which rising long-term yields will lead to losses for the whole financial system.  Financial actors' capacity to manage interest rate risk will be key. For European banks, we think the risk is well controlled overall and subject to strict regulation and supervision. For nonbanks, the quality of interest risk management is harder to gauge.

The amount of liquidity with which banks will either wish to operate, or be required by supervisors or the markets to operate.  This will surely influence banks' response to declining deposit volumes in terms of the amount of loan tightening that they will need to do. There is no direct precedent for quantitative tightening in Europe, and banking regulations have expanded over time to include stricter liquidity and funding requirements.

Negative news about profitability and higher realized or unrealized losses on investments and credit portfolios could lead to market concerns about banks' health and increase volatility in their funding conditions. As we saw in the U.S. earlier this year, market reactions can quickly escalate when banks are hit by a stream of bad news.

Central banks are equipped with several tools to address financial stability concerns. They have also shown that they can react quickly--for example, the BoE during the U.K.'s liability-driven investment crisis--and proactively create new instruments--for example, the ECB's transmission protection instruments--to counter unwarranted market movements on sovereign spreads. As for the provision of liquidity to the banking system, standard monetary operations and emergency liquidity assistance programs provide flexibility to deal with solvent but illiquid institutions, providing they have sufficient collateral to pledge.

However, central banks can only provide direct funding to banks. Nonbank financial institutions, for example, open-ended investment funds, do not have access to central bank refinancing facilities. Should financial stress occur in the nonbank sector, central banks could still intervene in the financial markets, for instance to avoid fire sales and negative feedback loops. Nevertheless, we expect the bar for such intervention to be very high, meaning that contagion risks to banking systems would need to be imminent and severe.

Uncertainties around nonbank players' access to liquidity could exacerbate market stress and the implications for financial stability. For banks, this spells the need for careful management of the risks emanating from their business with nonbank financial actors. We believe that traditional banks are now more aware of and able to manage counterparty credit risk, but we remain mindful of the contagion risks that nonbank players pose to banks.

Appendix: Quantitative Tightening And Its Impact On The Financial System

Quantitative easing involves the central bank creating new excess reserves to buy bonds in the market, thereby pushing liquidity into the financial system and leading to the creation of bank deposits. Under quantitative tightening, the central bank removes excess reserves on repayment of the maturing bonds' principals, thereby draining liquidity from the financial system and reducing the stock of bank deposits. Either the borrowers repay the central bank using their bank deposits, or they refinance the maturing bonds through private investors, who themselves draw on their bank deposits. The consequences of quantitative tightening vary for the different financial actors.

For borrowers (mainly governments, but also corporates), quantitative tightening means that a large investor is withdrawing from the market. They will therefore need to meet their future funding needs through private investors, which will be more expensive. Borrowers will seek to optimize their funding costs, potentially by reducing the tenors of their issuances.

For private investors, quantitative tightening provides a new opportunity to lend to borrowers, likely at higher rates. In accounting terms and all else being equal, they will use their bank deposits and turn them into bonds for the borrowers.

For banks, quantitative tightening means a decline in deposits and corresponding cash reserves as they carry out borrowers' decisions to repay maturing bonds, or private investors' decisions to lend to borrowers.

Table 2

Table 3

Related Research

• Credit Conditions Europe Q3 2023: The Slow Burn Of Rising (Real) Rates, June 27, 2023
• Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain, June 26, 2023
• Economic Outlook U.K. Q3 2023: Higher Rates Start To Bite, June 26, 2023
• European Banks' Asset Quality: Tougher Times Ahead Require Extra Caution, April 20, 2023
• When Rates Rise: Risks To Global Banks Could Emerge From The Shadows, Feb. 16, 2023
• The New Normal For Eurozone Banks: Strong Funding Franchises Are Back In Vogue, July 7, 2022
• When Rates Rise: Not All European Banks Are Equal, June 8, 2022